Diamonds in the Rough

Forget the myths. This is how venture capital really works.

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Here's everything you need to know about venture capital, in four acts:

1. Have an idea. Original ideas are preferable, but marketable ones are better. Also acceptable are slight variations on already extant ideas--make someone else's brainchild faster, cheaper, smaller.

2. Get a garage. All venture-capital success stories need a garage, as in "We were just two guys working at night in my garage when Kleiner Perkins showed up."

3. Execute the idea only to the degree that you can hint at the potential of how huge it'll be when you get a few dollars to "do it right."

4. Clear a parking spot for the dump truck full of venture money that'll be pulling up at any moment to buy a chunk of your company.

Did I miss a step? Not really. The world of venture capital is mysterious, thrilling, high-risk, and misunderstood. But perhaps its most fascinating element is how closely tied these early-stage financiers are to the operations of the companies upon which they shower their riches. And that's where there's a lesson to be gleaned. The best venture capitalists select companies that innovate, possess an early lead, have a workable plan, and are run by people they respect. In short, the exact same factors any individual investor should seek for his portfolio.

Neil Weintraut is more closely tied to the founding of Internet companies than perhaps any other individual. As a banker at Hambrecht & Quist, which made its bones on the Internet, Weintraut underwrote Netscape, UUNet, Lycos, and others. In 1996, he founded 21st Century Internet Venture Partners, and he's visited countless garages in search of places to park his dump truck. But the thing is, he's selective.

"We get approached by start-ups all the time," he says, "and more often than not, I ask them, 'Look, send me a one-page e-mail, and here's the first question I want you to answer: What problem are you solving?' You'd be amazed how many start-ups cannot tell you that. They can explain at length how their Java applications are going to run better than classical software and how it's easier to program, but they can't tell me why the customer cares. People like us really aren't about money. Silicon Valley is awash in money. If all we were was a broker of money, our role in life would be more at risk than a stockbroker's. What we're selecting is not quote-unquote 'the idea.' You can't just have one innovation, throw it at customers, and then go to the islands. That innovation is a starting point for you to perpetually innovate for the rest of your life. And the day you stop innovating is the beginning of the end of your company. When you launch a start-up, what you have done is created the opportunity to get out front and run like hell."

Right now, the company that's got Weintraut most excited is BigWords, a sort of Amazon.com for college textbooks. He makes his case, and it sounds appropriately promising--they "get" the college market, they've employed student reps to do nothing but throw parties, and their proprietary distribution system is peerless. I'm talking to him on the phone when all of a sudden the cherubic CEO of BigWords comes on CNBC. Weintraut, who's analytic to an extreme, goes nuts with pride when I describe the image of all these dozens of twenty-five-year-olds in bright-orange BigWords shirts. "No, he's actually twenty-four! Good--good for them!"

I'm half ready to put my own dough to work with these guys (I'm partial to overachieving college dropouts), when I remember the best investing advice I ever got: Stay away from "story stocks." In fact, BigWords is one of at least seven sites aimed specifically at selling textbooks to university punks. Promising? Yes. A sure thing? Not even close. And Weintraut, for all the paternal joy he takes in the company's successes, knows it.

That's the thing about modern venture capitalism. It looks a lot more like parenting. Time was, a company with huge losses and pygmy revenues couldn't clean the ashtrays of a respectable VC firm. Not anymore. It's a seller's market for those pawning equity in promising early-stage companies. So much so that companies gravitate toward the venturers who can promise not the most money but the best hand-holding.

Pierre Omidyar founded eBay as a way to round up bids on his fiancee's collection of Pez dispensers. Omidyar is a gracious and soft-spoken man, so it's no surprise that he gives his venture partners credit for the success of one of the best ideas, like, ever.

"I started this part-time and really only quit my job when the revenue from eBay was more than I was making at my day job," he says. "When we went down and sought venture capital, it was not for the money. In fact, we have only one venture-capital partner, Benchmark Capital. When we got their cash, we put it in the bank, and we haven't touched it since then. Unlike a lot of struggling start-ups, we had it easy. We did not need the money. What we really were looking for in a venture partner was actually a partner. The role that Benchmark played in the early days was tremendous--strategic direction, understand- ing what the business is about, and the advice and counsel that I received from [general partner] Bob Kagle."

If Omidyar sounds like an appreciative son, the feeling flows both ways: eBay's offering price was $18, and the stock is now trading at $144.

One of my favorite venture capitalists is Ann Winblad, a small-town, cheerleading Minnesotan turned programmer turned founder of Open Systems turned millionaire (sold Open Systems) turned partner at Hummer Winblad Venture Partners. Winblad lends some perspective to the notion that anyone can show up and expect funding.

"Our job is to audition the future," she says. "We see trends before they happen. We see pieces of the market open up and disappear as we audition the future every day. The top venture firms must make sure they get the best deal ?ow--you do not want to be picking from the runts of the litter. If we see an opportunity, and no plans or entrepreneurs appear, we will go out and look for them. But we most likely get batches of plans with the same approximate market targets and then can pick the best team."

• Can the team do it? (Winblad says that they spend as much time as possible with the team and check references whenever they can.)

If the starting team cannot do it, is it willing to accept a new leader, and can one be found?

"We have very little time to com-plete this process, sometimes just a couple days," says Winblad. "We fund less than twenty new companies a year and review close to three thousand submissions."

Winblad tells a great story of what it sometimes takes to stand out from the crowd: "Once a quarter, one of our partners here does a one-day stint at the Software Development Forum, where we sit there for a day, and every half an hour somebody new comes in and pitches us. They pay $50 to the center as a contribution, because they're a nonprofit. It's sort of a mix between The Gong Show and The Ed Sullivan Show--guy walks in and says, 'I can control networks with brain waves.' Well, a little hard to believe. And the demo was poorly executed.

"But Gerry Kearby called and said, 'I heard on the radio Ann's going to be there. Can I have one of those slots?' And they said no, the slots have been filled for a long time. He said, 'Did anybody cancel?' And they said no. So he said, 'Well, did anybody's check bounce?' They said yes, and he said, 'I'll be right down.' And he showed up and said, 'Look, I'm going to revolutionize the music industry.' "

Kearby walked out with a commitment from Winblad to fund Liquid Audio.

Right now, the company floating her boat is eHow, which provides information, Winblad says, on "how to do everything, from shaving your legs to washing your cat. Probably shaving your face, in your case." Winblad is funny. She speaks of the company and its CEO, Courtney Rosen, like a Little League parent whose kid not only homered but displayed good sportsmanship.

"I had ten young women over, and they could all ask questions about building their business and whatever, and Courtney Rosen--it was like the other people were four inches tall and she was ten feet tall. Her questions were so crisp. I asked, 'Could you stay after class?' Two weeks later, we offered her a term sheet."

Weintraut concurs. "When we look at a company, we're not looking at it in the form of 'Can we drop money here and come back from Bermuda two years from now and cash out?' " he says. "We're in early with the companies, when they're truly forming. So a typical company we back is literally the proverbial two engineers in a garage. I get involved with everything from introducing them to real estate agents to actually putting a roof over their head to fostering business-development relationships between, say, Yahoo! and the company. About $4 billion per quarter--more than half of all VC money--now goes to Internet ventures. Some venture firms have even emerged from the shadows to serve as quasi-marketing hooks for the companies they back. A goofy stock called Information Management Associates rose on the news that the VC branch of CMGI had invested. Publicists now call me to say I should look into an Internet insurer, since Softbank was backing them."

The culture of venture capital is all but irresistible. Unearthing an idea as promising as eBay and buying a stake at pennies per share fulfills both requirements of a killer trade--it's ridiculously profitable, and it simply feels good. But the style of a venture capitalist can't be replicated by the individual investor. Because there's no way for regular joes to buy into companies at a fraction of their IPO prices, you can't make a living investing in nineteen dogs for every one company that succeeds. And you shouldn't yield to the temptation of story stocks, whose histories are often more seductive than their balance sheets. But the core principle remains intact for any capitalist and any venture: Belief in a company--in its ideas, people, execution, and good fortune--can be a criterion not just for the profitability of an investment but for the sheer joy in it.

For more on money, including tips and My War updates, visit esquiremag.com.

My War: The Scorecard

A monthly look at my real-money portfolio. I started 1999 with $16,823.

Kind of a strange month. I remain comfortably perched atop the S&P, having done better than three times the index thus far this year. And some of my stocks--notably Dell and Sun--have reached or neared all-time highs, while DoubleClick showed renewed vigor. But others--Oxford, Pepsi, Summit--just refuse to play ball. With health care, beverages, and banking represented, blame cannot be placed on any one sector.

Just one trade this month. With a heavy heart, I sold all 50 of my Valence shares for $5 on August 23. I made about 44 percent on that round-trip, but I'd left a wad of cash on the table when the stock was in the mid-7's. I still believe in this company's opportunity, so it was a shame to sell, despite a nice gain. But the carnage in small stocks defies explanation, and it's becoming increasingly difficult to justify continued faith when the whole market seems to have no use for any non-Internet company too small for the S&P 500. I mean, look at WAVC and TEKI--both companies seem to be executing, but they just can't get on the radar. No point in selling either of those so deeply underwater, so VLNC had to be the fall guy for a trend that's as mystifying as it is unfair. At least Excel is holding up beautifully.

Sun had tons of good news, most of it attributable to the core reasons I bought the company--it innovates faster and harder and smarter than anyone else. (See my piece on Sun cofounder Bill Joy on page 128.) Sun's new MAJC chips are aimed at nondesktop devices, and the company's acquisition of Star Division, which makes computer applications that reside on the Internet rather than in your desktop PC, continues to position Sun for the post-PC, post-MSFT-Ã¼ber-alles world.

Under no circumstances does the information in this column represent a recommendation to buy or sell specific securities. The portfolio is for instructional purposes only.

If things seem awfully quiet on Wall Street these days, maybe that's because so many people are whispering.

Here's how it works: Investors look to a company's quarterly earnings announcements as religious events. Analysts at investment banks estimate these profits and report their predictions to several agencies (such as First Call), which collate all the divinations into a consensus earnings estimate. Then the company reports the actual number, and investors punish the stock if it's lower than the estimate and rush in if it's higher. Simple, except for one thing: The consensus is usually wrong.

Traders, investors, and even analysts in search of better numbers are tapping one another on the shoulder and sharing what they really think a company is about to announce. This isn't news: Investors have always shared their thoughts. What's novel is that the "whisper number" is gaining respect to the point that it's becoming a trackable, accountable phenomenon--and it's often more accurate than the "real" estimate.

Whisper numbers arose in reaction to two trends: (1) the blitzkrieg of interest in volatile Internet stocks, which react forcefully and immediately to earnings reports, and (2)the toadiness of the analyst system, in which herding is so prevalent that it's created a gulf between "consensus" and reality.

But the point is, are these numbers even useful? According to the first-ever study of the phenomenon, that would be a "Hell, yes." "Whisper Forecasts of Quarterly Earnings Per Share," conducted by Mark Bagnoli, Messod D. Beneish, and Susan G. Watts, holds that "whisper forecasts are, on average, more accurate than First Call forecasts." So how can you profit from this information?

Well, bear in mind that whisper numbers are virtually always to the upside of the official consensus estimate. That figures, since analysts tend to shave a bit from how they really think the company will do--it's dangerous for them to send investor clients into a company that disappoints, so the numbers tend toward the conservative side. That reluctance to tell the truth at all costs is exactly what's left the door open to a couple of nifty sites devoted to letting non--Wall Streeters in on the latest shhhs: whispernumber.com and EarningsWhispers.com. Both employ a sort of democratic "What do you think Company X will do?" approach and supposedly have mechanisms in place to weed out touters.

The whisper-forecasts study confirms that official forecasts "tend to underestimate earnings." But it also notes that "whispers tend to overestimate earnings." This means that the actual number is often between the consensus and the whisper. Yahoo!, for example, recently announced a gain of 11 cents, which was better than the 8-cent consensus estimate and worse than the whisper of 12. The stock responded by joining the downward march of Internet stocks. In other words, it was punished for missing the whisper instead of rewarded for beating the consensus.